Bank of America and JPMorgan Chase, will continue to dominate the financial system. And, since the federal government has now demonstrated that it will do what- ever is necessary to prevent the collapse of the largest financial firms, their top execu- tives will have an even greater incentive to enter perilous lines of business. If things turn out well, they will receive big bonuses and the value of their stock options will in- crease. If things go wrong, the taxpayer will be left to pick up some of the tab. Executive pay is yet another issue that remains to be tackled in any meaningful way. Even some top bankers have con- ceded that current Wall Street remunera- tion schemes lead to excessive risk-taking. Lloyd Blankfein, the chief executive of Goldman Sachs, has suggested that trad- ers and senior executives should receive some of their compensation in deferred payments. A few firms, including Morgan Stanley and DBS, have already introduced "clawback" schemes that allow the firm to rescind some or all of traders' bonuses if their investments turn sour. Without di- rect government involvement, however, the effort to reform Wall Street compen- sation won't survive the next market up- turn. It's another version of the Prisoner's Dilemma. Although Wall Street as a whole has an interest in controlling ram- pant short-termism and irresponsible risk- taking, individual firms have an incentive to hire away star traders from rivals that have introduced pay limits. The compen- sation reforms are bound to break down. In this case, as in many others, the only way to reach a socially desirable outcome is to enforce compliance, and the only body that can do that is the government. This doesn't mean that government regulators would be setting the pay of in- dividual traders and executives. It does mean that the Fed, as the agency primar- ily responsible for insuring financial sta- bility, should issue a set of uniform rules for Wall Street compensation. Firms might be obliged to hold some, or all, of their traders' bonuses in escrow accounts for a period of some years, or to give exec- utive bonuses in the form of restricted stock that doesn't vest for five or ten years. (This was similar to one of Blankfein's suggestions.) In one encouraging sign, officials from the Fed and the Treasury are reportedly working on the details of Wall Street pay guidelines that would ex- plicitly aim at preventing the reëmergence of rationally irrational behavior . "You don't want people being paid for taking too much risk, and you want to make sure that their compensation is tied to long- term performance," Geithner told the Times recently. The Great Crunch wasn't just an in- dictment of Wall Street; it was a failure of economic analysis. From the late nine- teen-nineties onward, the Fed stubbornly refused to recognize that speculative bub- bles encourage the spread of rationally ir- rational behavior; convinced that the mar- ket was a self-regulating mechanism, it turned away from its traditional role, which is-in the words of a former Fed chairman, William McChesney Martin- "to take away the punch bowl just when the party gets going." A formal renuncia- tion of the Greenspan doctrine is overdue. The Fed has a congressional mandate to insure maximum employment and stable prices. Morgan Stanley's Stephen Roach has suggested that Congress alter that mandate to include the preservation of financial stability. The addition of a third mandate would mesh with the Obama Administration's proposal to make the Fed the primary monitor of systemic risk, and it would also force the central bank's governors and staff to think more critically about the financial system and its role in the broader economy. It's a pity that economists outside the Fed can't be legally obliged to acknowledge their errors. During the past few decades, much economic research has "tended to be motivated by the internal logic, intellec- tual sunk capital and esthetic 0 puzzles of established research programmes rather than by a powerful desire to understand how the economy works-let alone how the economy works during times of stress and financial instability," notes Willem Buiter, a professor at the London School of Economics who has also served on the Bank of England' s Mone- tary Policy Committee. "So the economics profession was caught unprepared when the crisis struck" In creating this state of unreadiness, the role of free-market ideology cannot be ignored. Many leading economists still have a vision of the invisible hand satisfY- ing wants, equating costs with benefits, and otherwise harmonizing the interests of the many. In a column that appeared in the Times in May, the Harvard economist Greg Mankiw, a former chairman of the White House Council of Economic Ad- visers and the author of two leading text- books, conceded that teachers of fresh- man economics would now have to mention some issues that were previously relegated to more advanced courses, such as the role of financial institutions, the dangers of leverage, and the perils of eco- nomic forecasting. And yet "despite the enormity of recent events, the principles of economics are largely unchanged," Mankiw stated. "Students still need to learn about the gains from trade, supply and demand, the efficiency properties of market outcomes, and so on. These top- ics will remain the bread-and-butter of introductory courses." Note the phrase "the efficiency prop- erties of market outcomes." What does that refer to? Builders constructing homes for which there is no demand? Mortgage lenders foisting costly sub- prime loans on the cash-strapped el- derly? Wall Street banks levering up their equity capital by forty to one? The global economy entering its steepest downturn since the nineteen-thirties? Of course not. Mankiw was referring to the textbook economics that he and others have been teaching for decades: the eco- nomics of Adam Smith and Milton Friedman. In the world of such utopian economics, the latest crisis of capitalism is always a blip. As memories of September, 2008, fade, many will say that the Great Crunch wasn't so bad, after all, and skip over the vast govern- ment intervention that pre- vented a much, much worse outcome. Incentives for exces- sive risk-taking will revive, and so will the lobbying power of banks and other financial firms. "The window of opportunity for reform will not be open for long," Hyun Song Shin wrote recently. Before the political will for re- form dissipates, it is essential to reckon with the financial system's fundamental design flaws. The next time the struc- ture starts to lurch and sway, it could all fall down. . NEWYORKER.COM/GO/ ASK A live chat with John Cassidy.